The Hindu Business Line : Trading on options volatility

TRADING options is not an easy task. Ask any professional trader and you sure are going to hear that the risk involved is considerable. But at the same time, the returns too can be phenomenal. There are different modes by which one can make money with options. For instance, one can initiate a spread trade or if one has a long portfolio, he can initiate a covered option position. But ultimately all position take into account three significant parameters. If you want to trade options and be successful doing so then it pays to focus on:

the price of the underlying asset

the time to expiry and

the volatility of the asset.

While the price of the underlying and the time are clearly defined variables, what has managed to elude successful estimation has been the volatility.

Many option traders consider taking a directional bet on the stock. For instance, they try to predict the movement of the stock in the spot market and take a position in the option market based on their inference. There are other traders who trade on the time value of the option and try to make money. But there are yet another set of traders who try to trade volatility and make money.

Trading on volatility: Volatility traders use two fundamental parameters to assist them in decision-making.

The first tool is Implied Volatility. As a trader would know all option pricing models require an input parameter, which is volatility. Therefore the implied volatility factor is the volatility that has been factored into at the time of pricing the option.

* The other major tool is the Statistical Volatility. Statistical volatility refers to the volatility of the underlying asset measured over time. The simplest form of measuring statistical volatility would be to take the standard deviation of the asset over time.

Selling volatility: Now the key aspect of trading volatility would be a comparison of the implied and statistical volatilities. For instance, if the implied volatility of an option contract is particularly high while at the same time the statistical volatility has not budged much, it is an indication that the option is overpriced. Therefore, selling the option is warranted. Now it would also make sense for the investor to consider the kind of option that he wants to sell. This is where an options traders' standard tools, "Vega" comes into the picture.

The value of Vega: Vega measures the sensitivity of the option price to changes in volatility. Therefore, if one is selling volatility, the Vega should be higher. This means that selling longer-term options would be a better idea when selling volatility? Why so? Longer-term options tend to have higher Vega and therefore are likely to increase the probability of success to the trade.

Buying volatility: While we have sent that selling volatility helps making money it is also true that buying volatility might help. If the implied volatility of an option is lower than the statistical volatility then it is an indication that the option is cheap and traders could probably benefit from buying the option. Even when buying options it would be a better strategy to buy ones with longer terms as they tend to have higher Vegas.

Volatilkity skews: Another way of trading volatility is to take advantage of the volatility skews. What are volatility skews? In any given stock where options are traded some of the stocks are out of the money (OTM), some are at the money (ATM) and some of in the money (ITM). Therefore at times when one compares the implied volatilities of the OTM with ATM or ITM or any combination of the three we can find a difference. For instance OTM implied volatilities might be way higher than ATM or ITM implied volatilities. Skews can also arise between inter month contracts. For instance there might be a skew between the August maturity and the September maturity contract on Satyam Computers or for that matter any stock.

Now consider this position. Lets assume that we have the Satyam October trading at an implied volatility of say 64 per cent and the September maturity trading at 82 per cent. This means that's the skew, which is the ratio of the September volatility to the October volatility, works out to skew of 28 per cent in favour of the September maturity.

Now the trade that could be profitable would be to sell the long-term option and buy a shorter-term option to hedge this. Therefore, in our example we can see that we have sold the higher volatility option. In other words the time value tends to be costly. Therefore, this is would be a good position to be in. When volatility eventually returns to normal levels, the value of the short option will drop and it can be bought back at much lower levels leading to a profit. Therefore trading skews can be profitable. However, it involves some risk and new traders may want to experiment before trying it out.

(The author is a Research Scholar and Graduate Student with the department of Agricultural Economics at Kansas State University. Feedback is invited to anupmenon@hotmail.com)

If you have any queries relating to the futures/options markets and strategies that can be used in these markets, please mail them to Futures & Options, Kasturi & Sons, 859-860, Anna Salai, Chennai - 600 002 or email them to vaidy@thehindu.co.in with a mention of futures/options in the subject line.

Send this article to Friends by E-Mail

Stories in this Section
Tea: The overflowing cup of woes

`Industry should warm up by end-Sept' — Mr Homi R. Khusrokhan, Managing Director, Tata Tea

Pay telephone bills for prizes

Insurance Glossary

Huge bailout for UTI — No accountability

Will US-64 survive beyond May '03?

K-MNC: Sell